The bond market is in a turmoil due to the large borrowing program announced by the Centre. A war of nerves is currently on between the bond market and the RBI on where the yields should be. In this interaction with BusinessLine , Rajeev Radhakrishnan - CIO - Fixed Income, SBI Mutual Fund, shares his views on the current situation,

What is your view on the bond market’s ability to absorb the increased supply of government paper due to the government’s large borrowing program in FY21 and FY22?

The absorption capacity of the market is severely impacted. The market did not expect further Rs 80,000 crore borrowing this year. The Rs 9.7 lakh crore net market borrowing next year is also much higher than what most of us expected. The bigger disappointment is the RBI not announcing specific market intervention programs, given that the borrowing numbers are enormous. So far, the RBI has been reactive, doing passive yield curve control with specific actions implicitly targeting the 10y benchmark. Given that there is an enormous borrowing program that has to be conducted in a non-disruptive manner combined with the market’s reduced absorption capacity, there should be more forceful upfront intervention. This, unfortunately, has not happened. That is getting reflected in the bond yields.

The gradually recovering economic landscape also requires that financing conditions remain under control and the sovereign rates remain anchored.

RBI is sending the signal that it does not want yields to rise, will it be able to control the yields, what are the tools at its disposal?

The capital flows are very strong needing forex intervention that leads to excess liquidity in the system and constrains RBI’s ability to intervene in the bond market. I expected Market Stabilization Scheme issuances to be announced in the Budget and I am quite surprised that it was not done. From October, November 2020, we have had large capital flows, amounting to more than $10 billion. It’s clear that these flows will continue due to external events and benign global risk-free rates, thereby ensuring that large capital flows may have to be considered as a near term base case assumption. The MSS tool was created to sterilize rupee liquidity arising out of Fx interventions and that is unfortunately not being provided for.

Right now, the market does not have visibility on RBI’s open market operations schedule and that will be manifested in auction bids. Once the market gets that visibility that the RBI will do a certain quantity of intervention, either through operation twist or OMO, the tug of war between market and RBI on yields can cease.

What are your views on where bond yields are headed in FY22?

Given that we have a higher supply schedule than expected, and we have RBI intervention that is uncertain, there is fear that there will be gradual inching up of yields. Already the 5.90 per cent level that RBI was defending for a while has been pushed up to 6.10 per cent.

There will be RBI intervention at a higher level, but the risk remains that yields will drift higher gradually.

What do you think about the move to allow retail participants into G-Secs directly through retail direct? Will this work?

It is a perfect idea to allow retail investors in government debt and RBI has been trying to do this for a while. But it may not have an immediate impact in enabling a new source of demand for Government securities. If the government had provided some tax break in the Budget maybe even as a one-off measure for retail investors, it might have worked immediately. However, as a long term measure, this is positive and provides retail investors with direct access to a credit risk-free product.

Despite the higher rates in India than in the US and Europe, FPIs are not really showing appetite for Indian debt; they net sold $14 billion of Indian debt in 2020. What’s the reason?

The FPI outflows in calendar 2020 should be seen in the context of a weaker economic growth outlook which could have led to concerns surrounding India’s debt dynamics, its impact on currency markets, an elevated CPI reducing real returns and any potential rating migration concerns. However, foreign portfolio investors have received decent dollar returns on Indian debt as the rupee has been quite stable during the pandemic.

One issue with the Indian debt market is that FPIs find the access rules are quite restraining. Two, in the current context, foreign investors face the same issue as domestic investors in that they do not know the RBI’s intention on OMOs and the potential mark to market on holdings. And third, we are not in the global bond indices, which can attract foreign flows. Fourth, people are buying Indian bonds denominated in dollars raised by Indian companies on overseas exchanges. There are a lot of dollar issuances happening this year too.

I will not be surprised with FPI inflows into debt resume this year, since these flows are influenced by the previous year’s experience concerning currency movement and bond returns.

What is the best strategy for investors in debt mutual funds?

Opportunities for capital gains are likely to be limited because the RBI is likely to stay reactive with respect to market intervention. A recovering economy should also lead to a gradual unwinding of crisis-era liquidity and monetary conditions. Accordingly, investors should get used to much moderate return on debt funds compared to the last couple of years. Debt fund portfolio strategy would be oriented around protecting capital with a directionally lower duration strategy than what we held earlier. And portfolios with flexibility in the mandate like dynamic bond strategy could be attractive subject to individual risk preferences for a medium-term horizon.

For investments with a short term time horizon, products such as ultra-short-term category may remain appropriate.

Do you think policy rates have bottomed?

Definitely. I think rates will remain on hold for a while. But liquidity will normalize first, sometime during this year. Maybe next year the policy rates will begin to normalize. The policy normalization would be a function of confidence in a self-sustaining recovery in economic growth.

Published on February 16, 2021